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November 12, 2010

Too Late for Commercial REITs?

According to Moody’s Investors Services, the Moody’s/REAL Commercial Property Price Index (CPPI) fell 3.3% from the prior month and was below its post-crash low of October 2009. In fact, the index was 45% below its October 2007 high point and at its lowest level since June 2002.

In 2009, Industrial/Office REITS had a 29% return and are up 8.58% year to date through September 2010. Retail REITs also performed well: up 27.2% in 2009 and 21.1% in 2010.

The contrast between property performance and REIT performance raises two questions: Why is there such a large divergence? And can industrial and office REITS continue to generate solid returns for investors?

Naturally, some advisors are cautious.

Michael A. Dubis, CFP, of Michael A. Dubis Financial Planning LLC in Madison, Wis., has extensive experience analyzing and investing in REITS. He believes that, “Anybody that’s going into a REIT today using short-term history as a guide, the only thing I think they can rely on is the volatility. I don’t think they can rely on the return assumptions.”

Consequently, Dubis limits his clients’ portfolio exposure to REITS and generally limits the allocation to 2.5%-5%.

Brad Case, an economist and vice president, Research & Industry Information at NAREIT (National Association of Real Estate Investment Trusts), explains the difference in returns as an issue of timing.

The Moody’s/REAL CPPI measures property values on the private side of the market. There is a considerable lag—several months or longer—between the time an investor decides to start evaluating properties, buys one and the transaction shows up in the Moody’s/REAL CPPI.

Even if some commercial property prices are stabilizing or moving higher, it will be a while before that trend is reflected in the index.

But have REIT prices gotten ahead of an anticipated upturn in rental income?

Case suggests investors consider the long-term nature of the property cycle, which he says is generally about 18 years.

“We’re basically about a year-and-a-half into the expansion and the downturn,” he says. “This downturn was particularly severe and long lasting-it lasted two years. So, if you’ve got an overall market cycle of 18 years and a downturn of two years, you’ve got an upturn of 16 years and we’re a year-and-a-half into it. Now, these are, of course, all just very, very broad numbers but that gives you a sense of where we are.”